How credible are management forecasts? Not very (page 1 of 3)

If it's better than expected, share prices can skyrocket - perhaps creating a ripple effect throughout the markets. If worse than expected, prices - and expectations - can come crashing down. Just look at Cisco Systems, which undershot its 2000 earnings projections by mere cents, causing shockwaves throughout the tech sector.

But in a perfect world, earnings reports shouldn't create such volatile reactions. That's because they have been preceded by the company's earnings forecast, initially released about 190 days before the end of the year. Of course, "perfect world" is the operative phrase here. That "perfect world" is one where you can take these earnings forecasts at face value. Unfortunately, according to Credibility of Management Forecasts, a new study by Wharton accounting professor Phillip Stocken and Wharton doctoral candidate Jonathan L. Rogers, that perfect world doesn't exist, and investors know it.

Rogers and Stocken looked at management forecasts, analyst forecasts, earnings reports, stock price response to forecasts, market conditions and incentives for forecast manipulation in 600 companies across a cross-section of industries between 1996 and 2000. They picked this period because it represented the first five years after Congress' 1995 enactment of the Private Securities Litigation Reform Act, which protected corporate managers from being sued over forward-looking statements made in good faith. Previously, such "safe harbor" provisions only applied to SEC filings.

Based on their study results, Rogers and Stocken concluded that managers face tremendous incentives to strategically manipulate their forecasts to achieve particular results in the marketplace. They also concluded that managers are more likely to act on these incentives if they think they won't get caught. Finally, they determined that the market realizes this, and looks skeptically at forecasts that are higher than analysts' expectations.

Stocken says this study raises real questions about the overall credibility of management forecasts, and reinforces the following points:

• Investors must be cautious when responding to management forecasts

• Managers need to develop reputations for truthful forecasting

• Private market forces may not be enough to deter management from issuing self-serving forecasts.

"We found that [if management is] more likely to be exposed as having lied or biased their forecasts, they are less likely to manipulate their forecasts," says Stocken. "Opponents of the 1995 legislation argued that [because of the difficulty of proving bad faith] it would provide firms with a 'license to lie.' Proponents, on the other hand, argued that private market forces would induce truthful reporting. What we find is that managers do strategically manipulate these forecasts ... Our study suggests that maybe we need to think about the appropriateness of the safe harbor provisions that have been provided."

Cynical Public?
One of the study's main conclusions is that management does indeed have strong incentives to strategically manipulate their companies' earnings forecast. For example, managers at financially distressed firms would likely feel compelled to give "good news" forecasts, meaning forecasts that exceed those given by analysts. This is almost purely a matter of self-preservation, Stocken says. If the firm has performed poorly, the manager wants to show the board that he's executing a business plan that will turn things around.